Why do stocks do well in inflationary environments?

Taking Stock

Kudzanai Sharara

There are several factors that an investor takes into account when making investment decisions. Inflation is one of those factors as it is a key macroeconomic variable that has a great impact on the stock market. 

If an economy experiences high inflation rates, then the real value of money declines which implies less purchasing power, less profitability and a reduction in the real returns on investments.  

Zimbabwe’s annual inflation rate for January 2022 slowed down to 60,61 percent while the month-on-month inflation rate in January 2022 was 5,34 percent shedding 0,42 percentage points on the December 2021 rate of 5,76 percent, according to official statistics from ZimStat.

However, despite falling, these inflation levels are still high and worrisome unless the investment returns are much higher.

If one makes a 50 percent return on investment, but inflation comes out at 60,61 percent, the investment’s real return is negative. Even if share prices appreciate, those capital gains would count to nothing if they are below inflation.

The other reason is that higher inflation usually brings higher interest rates in response, from both the central bank and banks. 

Increased costs of borrowing are not good for the economy in general and listed entities in particular. 

Currently, the RBZ bank policy rate is at 60 percent while the Medium Term Bank Accommodation (MBA) facility interest rate is at 40 percent.

Stocks also trade largely on corporate profits, and rising prices and wages, as well as interest rates, increase a company’s costs, which further erodes profits.

However, companies with high operating leverage have a significant advantage when inflation goes up.

The concept of operating leverage is simple: Businesses with greater fixed costs (think property, plant, and equipment) can amplify profits when the price people pay for their products goes up while their costs remain relatively intact as they already own the fixed asset investment. 

In other words, these companies can increase profits/margins because there’s a relatively small additional expense to produce their product.

While local inflation figures are still significantly higher than what prevails in the region, the slowdown for January is encouraging.

Inflation developments are very important to local stock market investors as stocks can provide some hedge against inflation as is the case now.

As at Wednesday this week, January’s average return on ZSE listed stocks is 8,97 percent (All Share Index). This is ahead of January’s month-on-month inflation of 5,34 percent.

Although investor returns on the ZSE can be above inflation the trajectory might not be good for company fundamentals.

While some companies can react to inflation by increasing their prices, the result could be a reduction in sales as some consumers cannot afford the higher prices given the level of salaries.

Inflation thus robs investors as they end up paying higher share prices with no corresponding increase in value. Paying more for less.

Inflation can also be used as a guide of the expected returns.

For example, if investors expect a return of roughly 10 percent year-on-year after inflation, and inflation is 56,4 percent year-on-year, then a gain of 70 percent (after taking into account transaction costs) is very good.

Theoretically, the slowdown in inflation should see the gains on the stock market slow down.

High inflation such as 60,61 percent in January, would see investors expecting gains above 60,61 percent over that period before factoring in expected returns. 

But if inflation slows to 20 percent as per RBZ forecasts for 2021, then expectations would be lowered in line with the new level of inflation.

In other words, when inflation declines, so do the inflated share prices.

There is however another way of looking at the slowdown in inflation developments. When inflation falls, consumers can purchase more goods, input prices go down, and revenues and profits go up.

This is good for share price appreciation and should see local investors continue to buy into the ZSE, but with a bias towards quality stocks.